All new traders at Forex keep asking the same questions: "Where the money goes after a trader makes a deposit; are there any guarantees that traders’ money will be paid back to them and how the profit is generated?" This article will give you answers to all these questions and familiarize you with the concepts of "segregated accounts", "liquidity providers", "ECN-accounts", execution of "Market Instant" orders and so on.
How to trade at Forex
First of all, a trader needs to register with a broker and makes a deposit. The amount of a deposit is displayed in the personal cabinet; however the money will actually go to the segregated account. A segregated account is an account in a reliable bank with a good record where the money of all traders is kept. The segregated account is not directly connected with a broker's account, which means that a broker cannot use clients' money for his/her operating expenses. The fulfillment of this requirement is strictly monitored by a regulator. With the help of some analytical programs the bank keeps control over individual sums of each trader; this is a specific of the bank accounting, which is not a sphere of traders’ interest.
Now, let’s review the procedure of opening a position. On the screen of the platform you will see the right moment to buy, say, a Canadian dollar and you immediately give a buy order to your broker. Your order is processed with the help of broker's software and is placed in the market of a liquidity provider.
To be more exact we can say that a broker has software, enabling to consolidate liquidity from the external providers. After the receipt of a trader’s order, the software automatically forwards data to the providers; receives their responses informing about demand and supply and then execute traders' orders at the best available market price offered by the providers.
Liquidity providers are major intermediaries connecting all participants of the world exchange market, including largest investment banks, such as Barclays, Morgan Stanley, Citibank, Deutsche Bank, Bank of America and others.
A procedure of executing a trader's order can be briefly described as follows:
- A trader places a buy order for a certain instrument at a fixed price;
- The other trader places a sell order for the same instrument. A glass is formed on the basis of traders’ orders and liquidity providers make their price offers;
- If the bid and ask prices are the same, sell and buy orders overlap;
- If traders’ orders do not coincide, the bids remain in the glass until a liquidity provider makes the best price offer and a trader is asked if he agrees to a new price;
- If a liquidity provider fails to execute trader’s order, his/her order is forwarded to the other liquidity provider.
Order execution can be displayed as follows:
So, a broker forwards each trader’s order to a liquidity provider, in its turn, a liquidity provider ensures that an order is executed at the best current price. If one trader makes an unsuccessful deal, the other will make profit. The broker earns exclusively on the spread (a commission for a transaction); a broker shares his/her profit with a liquidity provider.
A difficult moment of order execution is slippage. It takes time to fulfill trader's order. At the time when a trader sends an order for a transaction at a specific price, prices at the market can change and the order will be executed at a slightly different price. A profession trader realizes the importance of quick order execution (up to 0.5ms), which enables to avoid slippage, which is helped by ECN-accounts.
ECN - is an electronic communication network where clients’ orders go directly to a liquidity providers avoiding dealing centers and consequently, avoiding conflict of interest.
Conflict of interest is a situation when a broker uses insider information preventing execution of orders. In ECN system a broker acts as an intermediary, which ensures transparency of transactions and high speed of data transfer. Absence of slippage is also a big advantage of ECN.
The chart shows that electronic ECN, systems such as Currenex, Integral, Reuters etc. act as intermediaries between the brokers and banks. Note that even in the classical communication schemes brokers do not often have direct contact with a provider. For some of the brokers this information is confidential. Sometimes, liquidity ECN systems can be providers themselves. They are called STP-brokers.
Types of order execution:
- Instant Execution is an immediate order execution at the current price. If a broker cannot execute trader's order, he/she will make his/her own offer with the guarantee of order execution at the specified price (re-quote). A trader may or may not agree to a new offer;
- Market Execution is an execution at the best price. Although probability of order execution is almost 100%, slippage is still possible.
It is considered that Market Execution is a sign a broker’s reliability, since a trader’s order is displayed in the interbank, where the price is dictated by the market. In the case of Instant Execution, a broker has a chance for manipulation as he/she can reject a favorable price and offer his/her own price.
A-Book and B-Book work principles
Principle of relationships between a broker and a liquidity provider and international market is called A-Book. This system has been specified above.
However, there is also another system, called B-Book. In this system, all clients’ transactions are closed via the opposite transactions. That is, a client's order is not transferred to a liquidity provider (external market), but is executed by a broker. A broker or one of his traders will execute an order by way of clearing.
Brokerages using the system of B-Book are often called "kitchens". This is not an entirely correct term, because it is considered that a "kitchen" broker tries to take client's deposit in a possession, while brokers using B-Book system are interested in attraction of new clients, as they earn money on spread.
Features of a broker using B-Book system are the following: no information about liquidity providers, small amount of a deposit (for example, $10), restrictions for trading. Many brokers use both systems. If a trader does not have trading experience, has a small amount of deposit and uses a risky strategy, he/she will not be introduced to a market, as it is economically unprofitable. Transactions of such trader will be closed by way of the reverse positions of traders of the same broker and there will not be conflict of interests between a trader and a broker.
When a trader gains experience enabling him/her to take risk of a big deposit (in which case he/she will need to use a wider trading options (for example, instant order execution, etc.), a broker will offer a trader an A-Book system, that is introduce him/her to a foreign market.
A broker can use a system of internal clearing, or transfer transactions to the interbank market. A transaction of a trader can be transferred to the interbank market either through a brokerage house or through ECN-systems directly to liquidity providers.
Features of a reliable broker:
- ECN-account. A reliable broker is interested in increasing of the volume of transactions, as he/she earns money exclusively on spread. Liquidity providers do not deal with small volume transactions; therefore, availability of ECN-accounts is a proof that a broker works with the largest investment banks, which shows that you deal with a reliable broker;
- A trader is not restricted in choice of strategies. A broker is interested in a client’s successful trading and does not limit his/her freedom of action.
You can find the terms of trade on ECN-account LiteForex here. Lite Forex guarantees integrity and transparency of transaction execution! If you still have any questions about the ways of money transfers and transactions execution at Forex, I will be happy to answer them all!
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The content of this article reflects the author’s opinion and does not necessarily reflect the official position of LiteForex. The material published on this page is provided for informational purposes only and should not be considered as the provision of investment advice for the purposes of Directive 2004/39/EC.